Beat The Exchange Rate Volatility: Forex Hedging

Posted in Finance Articles, Total Reads: 3576
, Published on 09 July 2012

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The Indian rupee has historically depreciated at an average rate of 4% against the dollar post the economic liberalization of India in 1991. This does not mean that there has been a linear one way fall in the rupee. The post liberalization period has seen great volatility in the Indian rupee with rupee hitting a high of almost 39 in January 2008 to the present low of 55 in May 2012.

The effect of currency volatility and exchange rate has a major impact on 2 set of players – one are the importers and the other are the exporters.

India’s major exports include handicrafts, gems, jewelry, textiles, ready-made garments, industrial machinery, leather products, chemicals and related products. These industries are heavily impacted in case the rupee appreciates/dollar depreciates. The depreciating rupee also has a major impact on the Indian IT sector. This effect was markedly visible when the rupee peaked at Rs 39 in January 2008 which led many small Indian IT companies to shut shop.

India Imports petroleum products, capital goods, chemicals, dyes, plastics, pharmaceuticals, iron and steel, uncut precious stones, fertilizers, pulp paper etc. These industries are heavily impacted in case the rupee depreciates/dollar appreciates. India being a net importer is more worried about rupee depreciation than rupee appreciation which is why we see intervention by India’s central bank the RBI in case the rupee depreciates by too much in a short span of time. It is also a reason why Indian rupee is still not fully convertible.

The market forces that lead to appreciation of Indian rupee are

Increase in Exports from India,

RBI selling dollars as forex intervention,

Positive Trade Balance,

Increase in NRI forex remittance into India.

The forces that lead to depreciation of rupee are

Increase of imports into India,

RBI buying dollars to absorb forex inflow,

FII pulling money out of Indian economy and

Rise in Global commodity prices.

The fact that Indian currency is not fully convertible makes it all the more volatile. The business houses have to worry about both general market forces and RBI’s foreign exchange policy. The exchange rate varies due to both market forces as well as central bank interventions. The timing and quantum of these interventions are very difficult to predict so relying on a trend in the exchange rate becomes even more difficult. This makes forex hedging a necessity for doing business in India.

Hedging is a mechanism to beat currency Volatility/fluctuations.

Importers have a time lag between Order placement and Final Procurement; similarly exporters have a time lag between Order receipt and Final Delivery. While the orders for imports/exports are placed in advance the final payment is made only on delivery after this time lag. This time lag may be 15 days, 1 month, 3months or even 6 months depending on the nature of requirement and suppliers capacity to deliver.

Let’s take the example of a commercial vehicle manufacturer say Ashok Leyland, let’s assume that cost of manufacturing a vehicle for Ashok Leyland is Rs 5,00,000 of this say Rs 2,00,000 worth of components is imported by the company. The company sells this vehicle for Rs 6,00,000 making a profit of Rs 1,00,000 currently. The preparation for assembly of the vehicle starts as soon as the import order of components is placed and the costs are estimated on the prevailing day’s exchange rate.

Suppose the dollar rate is Rs 50 when the import order for components is placed. This import takes 2 months time to be shipped, suppose the exchange rate goes to Rs 55 when the payment is made. This 10% appreciation in dollar makes the imports dearer by 10% so import components cost rises from Rs 2,00,000 to Rs 2,20,000. Now if Ashok Leyland continues to sell the vehicle at Rs 6,00,000 its profit will fall from Rs 1,00,000 to Rs 80,000. So in-spite of 10% rise in costs the profit margins fall by 20%. For some companies which work on narrow margins this fluctuation is enough to wipe out their entire profit margin.

So what companies require is certainty so that they are not hit by abnormal price rise/fall and are able to maintain margins despite the exchange rate volatility. Now hedging comes in here and fills this gap of uncertainty.

Using Hedging we can lock-in prices of imports/exports that we are going to realize say 1 month, 2month or even 6 month down the line.

Hedging can be done either through banks or through exchanges.

Let us examine how we can hedge through banks. Banks allow us to hedge through Forward and Option contracts. The forward contract is an agreement to pay/receive certain sum of money at a fixed exchange rate that is decided at the time of entering the contract. An importer can book the forward contract at the forward rate prevailing on the day when he wants to enter the contract. For example if an importer wants to lock in the prices of the shipment worth 1 million USD at today’s exchange rate of Rs 50/dollar that he’s going to receive after 2 months, he can enter into a forward contract with the bank for the entire import bill of 1 million dollar for 2 months.

Once he enters this contract he’s bound to pay 1 million dollar at the rate of Rs 50 at the end of 2 months no matter the dollar goes to 55 or falls to 45. So this way we are locking the prices of dollar and staying hedged. For undertaking a forward contract the underlying documentation and letter of credit is a must and a 5% margin of the entire contract value needs to be maintained with the bank.

The other way to hedge is through options contract where we need to pay a premium upfront to enter the contract. The premium may be Rs 1 or Rs 1.5 or any amount depending on the interbank rates. Options contract are exercised when they are in the money otherwise they go worthless and premium is lost. The buyer of the options contract has the right but not the obligation to complete the contract.

Let us take the above example of the importer who buys options contract at Rs 50 paying the upfront premium of Rs 1 for a 2 months period, if at the end of the 2 months the dollar moves to 53 then the importer will exercise his option. He will exercise the option and buy dollars at Rs 50. His cost will come to Rs 50 +1 (premium paid) = Rs 51. Now similarly the dollar can fall to Rs 48 after 2 months in such a case he will not exercise his option of buying dollars at Rs 50. His premium of Rs 1 will be lost and he can buy dollar from the market at Rs 48. Thus his net cost comes to 48 + 1 =Rs 49.

Thus option contract can give us the additional benefit if the dollar depreciates by lowering our overall costs of imports. In case of forward contract our price stays fixed at Rs 50 but in case of an options contract the upper limit of importers costs will be Rs 51(for Rs 1 premium) and the lower limit can be anything depending upon the extent of dollar depreciation. The drawback of options contract is that it is only available to those companies which have a net worth of at least 300 crores and the upfront premiums are very high. More than 80% of hedging in banks is done through forwards the remaining 20% being options.

The other medium of hedging is through exchanges which offers futures and options contract. The futures are analogous to forwards offered by banks. The difference being in future no underlying is required to enter into a contract. Moreover the margin requirement is also less it is only 1.75% as compared to 5% asked by banks. The major advantage is the futures rate comes at a discount to the forward rates offered by bank, the difference being close to 10 paisa per dollar or even more. For a 1 million dollar contract the saving could be Rs 1 lac similarly for 10 million dollar contract the saving could be Rs 10 lacs or more. The same goes with options contract offered by exchanges as the premiums here are far less than those charged by banks and any one can buy options contract net worth not being a criteria.

The entire exchange system provides far greater transparency as rates are same for one and all unlike banks where rates vary from bank to bank and upon the size of the contracts. Thus in the future we will see many people shifting from banks to exchanges for inexpensive hedging. Futures/Forwards are known to be better it terms of hedging effectiveness than options but a hedger would have to decide whether the extra risk protection afforded by the attractive risk profile of options is worth the loss in hedging performance.

A recent report by RBI stated that more than half of corporate India’s forex exposure was unhedged. Thus there is a dire need of hedging awareness and corporate India must be proactive in hedging rather than be found wanting and allowing currency fluctuations to wipe out their entire profit margins.